But those facts are not the whole story. A jump in fuel costs would be immediate and visible at the fuel pump. The interest rate drop would be only at the front end of the yield curve that goes from overnight to 30 years. After that, it’s the market that makes the moves. The 30-days part of the curve is the only section that is directly under U.S. Fed control. The rest, out to 30 years, is controlled by the market.

What it costs to fill your fuel tank therefore depends not on the usual business cycle, which would predict that a slowdown in gross domestic product (GDP) growth would induce the Bank of Canada and the Fed to cut rates. Today, fuel prices are heavily determined by missiles over the Middle East and what will inevitably be not so much stimulative as compensatory moves by central banks. In our case, that’s the Bank of Canada and the Federal Reserve Board in Washington. (Editor’s note: This column was written before the Bank of Canada’s Oct. 23 announcement cutting its target for the overnight rate to 3.75 per cent as well as the U.S. Fed’s Nov. 7 announcement cutting its own overnight rate range to 4.5-4.75 per cent.)

The present Middle East war, though horrible on the ground and for its many victims, has been kind to energy producers. But the war is growing, as Israel responds to the launch by Iran of about 200 ballistic missiles earlier this month toward Israel-based targets and also expands its military operations in Lebanon.

In the first week of October, oil prices rose by 10 per cent, to about US$78 per barrel. That would be just the beginning, for in 2022 when war broke out in Ukraine, oil prices zoomed to over US$100 per barrel. In the present situation, benchmark Brent crude, recently at US$81 per barrel, could soar. Though the U.S. is the world’s biggest oil producer, active oil prices depend on Middle East operations such as the Abadan refinery in Iran. It’s a target. Israel could strike it or the oil fields or terminals in the Persian Gulf, hitting refineries there and knocking a few per cent out of world daily oil shipments. There could be naval actions in the Persian Gulf that could restrict supply enough to make oil rise to US$130 per barrel, according to The Economist, a British publication.

READ ALSO: Global oil surplus expected to weigh down crude prices

The Fed and other central banks would not stand by. Chances are they would try to support business and consumers by reducing interest rates. There are as many forecasts for rate moves, even without wartime compensation, as there are banks and macroeconomists.

ING, a very large bank headquartered in the Netherlands, has predicted a fall in overnight rates to three per cent. Fitch, a credit rating service, has predicted a slow easing of rates to compensate for flowing growth of GDP in the U.S. as global gross domestic product falls from 2.5 per cent in the third quarter of 2024 to 1.6 per cent in the first few months of 2025. European markets expect cuts, surveys say. Same goes for China.

Cuts on the short end of the yield would help straighten out the yield curve which, recently, has posted lower rates in the two- to five-year space than rates for a few months. The distinguished monetary economist Tom Czitron, who writes for the Globe and Mail, makes the case that the Bank of Canada should cut rates to compensate for what has been declining real income for Canadian families.

What a ramp-up of energy prices will mean for interest rate forecasts has to be compared to the effects of US$100+ oil.

First, it has to be noted, interest rates are very democratic. They hit everybody, though in different ways, depending on where you are on the machinery lot. Lenders can charge more but they wind up lending less to business and farmers. Farmers and most businesses wind up paying more for loans and doing less business. To offset rising financing costs and higher consumer prices, central banks will lower interest rates aggressively, as they did, for example, in 2008.

The word on your bonds

Farmers, like everybody else, have to abide bouts of cost-driven inflation, but the prospect of interest rates pushed down by central banks opens the path to bond speculation. As interest rates fall, the prices of existing bonds with fixed coupons will rise. Riskless government bonds generate the largest gains in this process while riskier bonds, especially junk, can reflect the problem of selling enough goods to generate money to pay bond coupons and to redeem them when due.

Mortgage costs can drop with falling interest rates, but terms of bonds are carefully shepherded by lenders, lest they be caught out getting insufficient interest when they have to roll or refinance the money they have lent.

For farmers, oil-driven inflation could lead to higher earnings if central banks cut rates in 2025 with a one per cent drop and a further drop of 50 basis points in 2026 — a frequent forecast in the financial press. Core inflation of about 2.6 per cent in late 2024 could drop to 2.2 per cent or even two per cent for 2025. These are leading U.S. rates that the Bank of Canada would follow, if not match. The “coulds” and “mights” depend on Middle East conflicts.

The bottom line is that conflict can lead to higher fuel costs which, in turn, boost crop costs and market prices. Arbitraging fuel and crop prices will help or harm Prairie farmers who sell grains into a troubled world market.

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For starters, we need to clarify the difference between a bond and a stock. A bond is a solemn promise to pay interest for a defined period to a specified maturity date, and then to return the issue price of the bond. If you buy a $1,000 bond for $800, it’s a contract and if the borrower, which is the bond issuer, does not pay interest on time in the amount promised, bond holders can and almost always do sue for payment. They will get paid or get to own the company. That does not work for government bonds. Historically, the big issuers of government debt, including Canada, the U.S., major European countries and Japan, do not default. Note that countries have armies and are averse to getting seized.

Corporations that don’t pay, however, get pushed into bankruptcy by injured bondholders. Bond ratings, issued by agencies such as Standard & Poor’s, show the odds of payment or default, from AAA or AA+, which major governments and their agencies get, down to B+, which still is not bad, to C, which is not good, down to D, which means insolvent or just about. Bondholders can push defaulting companies into bankruptcy, which is why very few bond issuing companies fail to pay on time and countries which default can find their national airlines’ planes seized. It is very rare, and in those cases it can take years — decades, in the case of Argentina, a serial defaulter — but holdouts do get their cash.

In exchange for the greater security bonds provide in comparison to stocks, investment-grade bonds pay less on an historical basis than stocks. For example, in 2023, the U.S. Standard & Poor’s (S&P) 500 stock index rose 26.06 per cent, while U.S. corporate bonds with respectable Baa ratings returned a comparatively crummy 8.74 per cent. The stock index return was almost three times the bond return. What’s more, Canadian stock dividends get the dividend tax credit while bond interest is fully taxed. Stocks seem to win.

Not quite, though. In 1974, when the S&P 500 stock index dropped a breathtaking 25.9 per cent, Baa-rated corporate bonds lost just 4.38 per cent. In the long run, stock returns will certainly bash bond returns, but that long run can be 48- to 60-month stocks cycles. That means waiting as much as five years for stocks to recover. Bond cycles can be 30 years. That’s a long time for a person retiring in need of fairly certain income in years when he or she no longer earns income. The point is, bonds have their down years and long cycles, but most years bond indices drop only low single digits. Of course, every rule has an exception — at the low end of investment grade issues, Baa corporate bonds lost 17.83 per cent in 2022, though the S&P 500 stock average lost 18.04 per cent in the same year. That’s all in U.S. dollars. Even in a bad year, bonds lose less than stocks. And that is critical for retirees.

Rate expectations

If you do want to add bonds to your portfolio or add more bonds to what you already have, interest rate expectations are critical. Market observers are predicting a tough time for stocks in 2025. But in tough times, central banks such as the U.S. Federal Reserve and the Bank of Canada drop rates. It has not happened much at the time of writing, but a rate decline, even if distant, is a sure thing. In other words, we know it will happen, but not when or by how much.

As interest rates fall, existing bonds with known rates superior to rates being cut will be more appealing and should rise in price. Government bonds issued by the government of Canada, the provinces and big companies like the banks, CN, CPKC et cetera should rise in price to provide some compensation if and when their stocks decline. How much compensation depends on your own allocation to stocks and bonds. A financial planner can do the balancing work.

Picking corporate and government bonds and trading them in a cost-efficient fashion is not for small investors. Bonds are priced on buy-sell spreads and any trade less than $1 million for government issues and $5 million for corporates is likely to have a buy-sell spread big enough to scrape a few per cent off the return. That could be most or all of your gain.

The way to avoid these hatchet jobs is to invest in bond exchange traded funds (ETFs). Chartered banks, iShares, Vanguard and other investment fund managers offer dozens of varieties of U.S., Canadian and other government bonds and such things as international bond mixes. The fees for these funds are usually 1/10 of one per cent of portfolio value per year. There is some variation, so you have to check the issuers’ tables. Managed bond funds have much higher fees and trading charges than plain vanilla ETFs Those managed bond fund fees are often so high that they scrape the cash flow gains down to little or nothing. Always compare what ETFs charge to what managers charge for managing portfolios. On government bonds, ETFs always win. On some corporate bonds, junk and foreign bonds, managers can beat indexes, but if you want that kind of risk, you can just add stocks with, typically, rising dividends. Don’t accept risk without payment for it. For a portfolio, bonds should reduce risk. Taking on additional risk for interest rate gains or even defaults makes no sense.

Note that bonds have fixed maturity dates when you get back the face value of the bond. Stocks have no maturity dates, though with takeovers and buybacks, a return of some cash is possible. If you bought for less than the share price at these redemptions, you get a profit. If you paid more, you lose.

In the long run, which tends to mean a decade or more, stock returns will beat bond returns. There may be more pain, but patience can help. With the steady annual or semi-annual coupons from bonds, you get paid on time. Stocks dividends often rise; bond coupons, except on rate reset bonds issued by banks, do not.

I don’t think there is a one-size-fits-all rule for buying bonds. Managed bond funds seldom beat big index funds, so by all means browse Vanguard, chartered bank bond ETFs and iShares.

U.S.-based PIMCO (short for Pacific Management Corp.) is a huge and expert bond manager. Ditto RBC and other Canadian chartered banks Look for funds with management expense and related trading costs below 10 to 15 basis points. It’s all published data. You can buy most of these funds online and/or through online discount brokers. Remember that in comparison to stocks dividends, which can rise as noted, or fall, which is rare, bond dividends other than rate resetters are fixed. Resetters often apply a revised five-year interest rate plus a bonus for corporate risk. But if rates are falling, resetters can cut bond payments and prices. If you want to invest in resetters, get advice.

Don’t ignore interest rate risk and be prepared to hold bonds to maturity. If you invest at less than the issue or redemption price, you’ll get additional profit at redemption or as redemption approaches. And most of all, discuss any investment plan with your financial advisor, accountant or even lawyer if an estate plan is involved.

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The company issuing the annuity would prefer a sooner death, to cut short the payments of the simplest life annuities with no guaranteed minimum number of payments. Annuities are a mirror image of life insurance, in which the insurance company would like the person insured to live as long as possible, delaying payment of benefits.

Annuities have a curious history. They existed in the Middle Ages but they were often annuities in kind, for example, the right to hold land for the life of the beneficiary. In a financial setting, tontines — asset pools with income paid to surviving members — were sold by governments to raise revenue. Investors paid a sum to the government for the right to receive income and, at the death of an investor, his or her share would be reallocated among the surviving investors. Tontines led to much mischief, as you can imagine, for it paid to be a survivor. Tontines are not available in Canada for good reason.

In Canada, there are a handful of annuity varieties. None have incentives to do in other members of the pool. Each annuity is sold individually — what others do or how they fare has no bearing on what the annuity pays.

Annuities in Canada are just investment devices. You pay a lot of money for what, at present interest rates underlying the annuity, will be a trickle of income, For most people retiring with a fixed sum of capital, the annuity provides a rock solid guarantee of income backed by the insurance industry bailout fund called Assuris that will pay annuitants even if the insurance company becomes insolvent. It happened with Confederation Life when it became insolvent in 1994, but no annuitant lost money.

Canadian annuities are based on government bonds. At present, government bonds pay little so annuities have low payouts. Were government bond interest rates higher, annuities would have more appealing incomes. Annuities almost never cover inflation. Such coverage would reduce what they pay to a trickle. However, if one buys a ladder of annuities, say one every few years, inflation is automatically indexed.

The practicalities

Once you are in and getting paid, backing out of an annuity is difficult or impossible. Because annuities function under life insurance law, the payments have limited protection from lawsuits, though not tax claims by the Canada Revenue Agency. In sum, annuities are very useful for providing a known income for the life of the person receiving the money. They are a lousy way to build up savings late in life and usually a lousy way to receive savings in late life.

There are almost as many annuity structures and payment possibilities are there are pebbles on a beach. They vary by age of annuitant(s) at start of payments, guarantees of payment, jurisdiction, gender, immediate or deferred start, tax structure, and number of lives until end of payments.

Here are some examples from current annuity rates based on $100,000 starting capital. These are representative quotes. In actuality, there is a range of prices among insurance companies:

• Male, age 60, simple life annuity, no guarantee: receives $473 per month.
• Male age 70, simple life annuity, no guarantee:receives $633 per month.
• Female, age 60, simple life annuity, no guarantee: receives 432 per month.
• Female, age 70, simple life annuity, no guarantee: receives $559 per month.

If we add up the payments by year, for male at 60, the payoff is $5,676 per year, for a woman $5,184 per year. Displayed as interest, it’s 4.73 per cent and 4.32 per cent at 60, which is more than a savings account or GIC pays these days. But the annuity is illiquid, irreversible, and, with our example of no guarantee period, results in confiscation of capital at death. These are crap shoot odds and, personally, I would not take them.

If you add a guarantee period of 20 years, the payoffs drop to $434 and $493, respectively, for men and $413 and $475, respectively for women.

If the survival factor is reduced or eliminated for the guarantee period, the annuity pays less. These are term certain annuities. Thus a term certain for either gender at age 60 for 20 years pays $521 per month or $125,040 over the term of the annuity. That’s $6,252 per year or 6.25 per cent in crude interest disregarding potential compounding of payouts and the eroding capital base. It’s not bad, but when the 20 years are up, all the capital is gone and the payments stop.

The discouraging returns and retention of initial capital is less onerous when you consider that part of the return of the annuity is capital. That makes the crummy returns a lot more attractive.

Consider an annuity for $100,000 up front purchase price paid by a 70-year old man. He would receive $6,880 of income each year of which $1,000 would be taxable income. This tax advantage can be compounded by buying a ladder of straight life annuities. The payout increases with each year you get older and the relative tax advantage over straight interest grows as well. Annuities are for those who don’t want their capital back but who do want bulletproof guarantees of income.

Annuity calculations are designed to expend all capital at some defined time. The Department of Finance incorporates the annuity idea into Registered Retirement Income Fund tables. They have increasing payouts and are thus not pure mathematical annuities. For RRIFs established before the end of 1992, they start with payments of four per cent at 65 and 20 per cent at 96 and thereafter. Pure insurance annuities have constant payoffs, although in other countries, annuities can be structured to carry investment risk and therefore to pay more or less than the mathematically determined rate.

The upside of annuities is that they leave no risk for the annuitant other than inflation. That can be covered by buying a ladder of annuities with payouts rising alongside interest paid on the government bonds that power them. As to security, even during the Great Depression, not one insurance annuity failed. But there is a hidden cost in annuities: commissions. They are embedded in the rates, hard to figure out, and, alongside the lack of ability get your money back after the annuity starts, they are negatives.

Bottom line: annuities can be a solution for the elderly, for the infirm and even as a way to put a floor under a retirement income, leaving the annuitant to take on stock market risk without the danger of running out of money and winding up poor. If the annuity idea appeals to you, check with a financial planner and price a few annuities with independent insurance agents. The homework will be worth it.

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Normally, the curve rises gently from one day to 30 years, reflecting inflation expectations. If the yield-to-time relationship drops, it means several things: one, that there will be less inflation ahead. Moderate inflation is associated with economic growth. So no curve rise or even a drop means less growth or no growth and stagnation or recession to come. What’s more, after a fairly sustained rise since the end of the mortgage meltdown crisis of 2008-09 and the correction at the start of 2016, it’s time stock markets, many at all-time highs, take a break and reset. A collapsing curve of government bond yields would precede that event.

American investment bank Morgan Stanley recently told its clients that the U.S. Treasury yield curve would go flat in the third quarter of 2018 with the 10-year Treasury bond hitting a record low of two per cent.

Flattening to inversion

There is evidence that the process of flattening going to inversion is underway. Stock prices are high because interest rates are low. People take risk on stocks rather than holding safe government bonds because bond payouts are so crummy. A yield curve inversion would, however, tell people to take cover, sell stocks, and accept even lower bond returns. That would, in effect, be insurance against worse to come. Federal government bonds may be a poor way to earn income, but they never default.

A yield curve kink indicates two things: From the investor’s point of view, it’s evidence of people buying shelter through lower bond yields and accepting the cost in terms of lower returns. From the point of view of companies that sell bonds to raise money, it shows precaution for they borrow less and thus offer lower interest rates.

Where government bond yields go, corporate bond yields follow. It is worth noting that yield curve inversion, that is, the point where the curve stops going up and starts to head down, has predicted every North American recession in the last half century.

The inversion may be coming, but it will take at least some months. The main player is the Federal Reserve Board. For flattening or inversion to happen, the Fed has to push up short-term rates above present 10-year rates at least. That would mean that the three-month U.S. Treasury yield, now about 1.25 per cent, and Canada’s as well at one per cent would have to rise to two per cent. That’s not in immediate sight, but it could happen next year. If T-bond buyers prefer to go long and lock in money ahead of the dropping long rates that are part and parcel of a recession in combination with rising short rates, the kink would happen.

How sure a thing is the inversion? No one knows what the American administration may do. Uncertainty is itself a reason to buy Treasury debt, especially long debt to lock up money safely until the fog clears.

“The Fed has been wanting to raise rates for a couple of years and if it does, its overnight rate would rise from today’s effective rate of about 1.4 per cent by 1.6 per cent to three per cent. That would take at least a few meetings of the Fed’s rate-setting Open Market Committee,” says Edward Jong, vice president and head of fixed income at TriDelta Investment Counsel Inc. in Toronto. “We think that the Fed would be smart enough not to cause an inversion. Moreover, rising inflation is not yet a concern.”

What to do? Investment decisions based on political forecasts are dicey. Precaution suggests lightening up on stocks because markets are high. The potential of a yield curve inversion adds to the incentive to move to 10-year Canada or U.S. bonds for a recession that may yet happen. A yield curve kink is part of most recessions, but the timing remains uncertain. But the post-2008 to 2009 boom, which withered in 2015 and then restarted in early 2016, is almost a decade old. A stock market reset heralded by a kink in the government bond yield curve would just be part of the process.

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The 10-year U.S. Treasury bond, the world’s bellwether debt instrument, has recently been priced to yield 2.38 per cent, a little down from its recent peak yield of 2.62 per cent on March 13.

Bond yields are about risk and inflation. In the case of the U.S. 10 year T-bond, it’s also about risk, for U.S. inflation is a modest 2.3 per cent at annualized rates. For comparison’s sake, the 10-year Italian state bond carries a yield of 2.26 per cent and British 10-year sovereign bonds, called “gilts,” pay a modest 1.09 per cent with British inflation at 2.6 per cent. The U.S., it seems, is a bigger risk than Italy.

The stock market has been on a tear, up 12 per cent in U.S. dollar terms. Bond investors don’t believe it. The bond market is forecasting risk and trouble for the American economy while the stock market is aglow with rhapsodic investors who believe Trump will raise corporate profits. Who is right?

On average, stocks are priced at almost 30 times earnings, according to the Case Shiller Cyclically Adjusted Price Index (CAPE). This is the highest level since the tech bubble at its most optimistic in 2000. Professor Robert Shiller, a Nobel laureate who teaches at Yale, denies that this number implies a crash is at hand. Shiller suggests this means one should cut stock holdings and hold more cash and bonds. Put another way, when your stocks or any other asset is booming, take a little money off the table and diversify.

Stock market risks

A lot of risks could derail stocks. First, there is momentum. The S&P 500 index has not had a serious drop since Trump was elected. Second, there is President Trump’s wish for higher tariffs and trade barriers. This could reduce sales and profits for American companies. If the U.S. decides that American auto makers should not buy parts from China, higher costs of American-made parts for Fords and Jeeps would either raise sales prices, cut sales or reduce bottom line profits. Trump is bad for topline business even if he can deliver tax cuts on the bottom line.

Eventually, Trump’s policy of removing regulations to protect the environment will harm American output. Two recent executive orders from the White House — one, that coal mining companies need pay no penalty for dumping coal and waste into rivers and, two, that coal companies can mine on U.S. public lands, are symptoms of more regulatory rollbacks to come. Why does this matter? Because the un-priced or unpenaltied use of resources ultimately empties the cookie jar.

The Trump position that environmental regulations should be eliminated is going to be counterproductive. The Paris climate agreements are history from a U.S. point of view. China and India are big polluters but there is doubt that they will back the Paris accords if Washington does not. Visa restrictions for Mexicans may severely limit output in U.S. agriculture, especially in California’s fruit and nut belt. What drought has done in five years, Trump may equal in one, critics fear.

Some of this apprehension may be excessive. However, risks are rising. Trump proposes to reduce regulations that force banks to carry more capital to back their loans. That’s a return to the wacky lending standards that allowed NINJA loans (No Income, No Job, No Assets) to be liberally dispensed to people with no fixed address and no money. That was the malpractice underlying the mortgage meltdown in 2008 that nearly wrecked global finance. Could 2008 happen again? Not exactly, but pyramids of risk on bank balance sheets with highly leveraged capital are an invitation to another disaster.

Risks are rising in the U.S. stock market. Stocks magnify that risk. Investors tend to trade as a pack when they see stocks zooming up or tumbling down. On the up side, they bet on momentum continuing. When stocks are crumbling, there is a race to get out of the musical chairs. Stock markets that crash with 10 per cent drops in a series of days, or worse as in 2008 or 1987 when there were double digit falls during panic days, can do it again.

The alternative to stock risk

On top of high U.S. 10-year Treasury Bond interest, corporate investment grade bonds offer good returns and acceptable risk. For example, Canada’s insurance giant, Fairfax Financial Holdings Ltd., has a 4.95 per cent Canadian dollar issue with a BBB investment grade rating that yields 3.65 per cent per year to maturity on March 3, 2025. That is 2.19 per cent more than an eight-year Government of Canada bond, which pays 1.46 per cent per year to maturity and about the same yield as one could get from a public utility stock. To be sure, there are tax differences. In non-registered accounts, stocks dividends are puffed up for calculation purposes. That process increases taxable income and so can cause Old Age Security benefits to be reduced or lost.

Bond interest is not grossed up and thus does not have any magnified effect on OAS. An investor can cherry pick corporate bonds with investment grade ratings and, if Trump does no greater harm than the market expects, U.S. government and corporate bonds purchases will wind up diversifying your risks and provide a tidy return competitive with stocks dividends but with far more security.

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Some investment assets pay regular income. In this category are conventional bonds that promise annual or semi-annual interest payments and dividend-paying stocks that make no firm promises but that traditionally pay and even raise their dividends.

Assets that pay income on a regular and dependable basis tend to have market prices more stable than those which do not. The promise of income induces investors holding the stocks or bonds to keep them, even if their prices take a dip, and to defer sales even if there is a handsome profit to be had. The incentive to hold varies with the tastiness of the dividend. This causes stocks like telecom BCE Inc., with handsome dividends with little or no chance in sight to cut them, to have relatively stable prices. Meanwhile, stocks with modest dividends, such as Apple Inc., which competes in the dog-eat-dog tech industry, have volatile share prices.

Let’s look at what dividends — and dependable businesses, of course — do for the two companies, both in communications: BCE Inc., with landlines and cell services, among other things; and Apple Inc., a technology company that makes cell phones.

BCE Inc. has a 4.88 per cent annual dividend. Apple Inc. has a 1.67 per cent dividend. The gap between the dividends accounts for much — but not all, to be sure — of the ups and downs of their stock prices. BCE Inc.’s up and down are modest, those of Apple Inc. are dramatic. The measure of jumpiness is beta, a number which shows relative volatility. The beta of the market as a whole is 1.0. BCE Inc.’s beta is 0.16, very low indeed. Apple Inc.’s beta is 1.21. Thus BCE Inc. wobbles only 16 per cent of the amount of other stocks listed on the TSX while Apple Inc. outdoes its NASDAQ index by a fifth.

If we look at the price lines of the phone maker and the tech company, the differences are dramatic. BCE Inc.’s prices trace a relatively smooth line from $30 in 2010 to about $60 today. Apple Inc.’s price line moves from US$25 in 2010 to US$136 today. There is more involved than just dividends as a fraction of stock price, for Apple Inc. has grown its business and even culture extraordinarily well while BCE Inc. was and always will be a relatively dull phone service provider.

Bond variability

Bonds, too, show price wobbles consistent with the dependability of their interest payments. For bonds, that dependability, which goes from 100 per cent for U.S. Treasury and Government of Canada issues to “high” for top corporate bonds to “just good” for lower grades of investment-level bonds to “not so good” for junk bonds, especially those in the lower ranges of quality. Default rates 10 years after issue for government bonds are zero, for top corporate bonds 0.45 per cent in the U.S. and zero in Canada, for lower quality investment grade bonds 6.1 per cent for U.S. bonds and 3.8 per cent for Canadian issues, and a shocking 56.5 per cent for U.S. issues and 33.3 per cent for Canadian issues rated at the bottom of the junk heap. The market prices adjust for these risks, so that a U.S. Treasury or Government of Canada bond pays a couple of per cent for 10 years, solid corporate bonds double that, and chancy junk bonds can offer up to 50 per cent combined interest if it is paid and refund of bond price at maturity if it happens.

Getting paid on time is the essence of the problem. Bond holders almost always get paid, for even if a bond does default, the promise of payment can be taken to court. The resolution is that the bond holders, often after many years, wind up with stock in a reorganized company coming out of bankruptcy. Stockholders who are not paid dividends have nothing, for dividends are not guaranteed by anybody and, technically, the stockholder’s only right is the essentially meaningless one of voting for directors.

More risk, more return?

What does all this mean for your own investment policy? If you get upset by market swoons, go for low volatility stocks or dividend-focused exchange traded funds and mutual funds. If you believe that what goes down will bounce up, as usually happens with broad indices, and if your stomach can take the ride, then volatility may be less of a problem.

Some say that if you take bigger risks, you can have bigger returns. Over periods of centuries, it is true. But one’s lifespan is not centuries and the concept only works for very broad blends of assets. If you go back to 1800, then zero volatility cash has a low negative return from uncompensated inflation erosion, more volatile bonds have a higher return, and stocks with far more risk and no promises at all have a still higher return. But for any one stock or any basket of conceptual stocks (think of the dot coms that nearly all flopped), it does not work. After all, if a company goes bankrupt, which is the ultimate risk, that’s it for compensating return.

Bottom line: do not embrace risk you cannot afford. That is the concept, but how do you put it into practice?

For most investors, picking one level of risk bundled into just one concept is wrong. Why? Because everything in investment markets is fluid. The most solid government bond bought for $1,000 could slump hundreds of dollars if interest rates rise a good deal. That seems unlikely right now, but over a 20- or 30-year life of a long bond, it can happen. It did in the late 1970s and early 1980s when interest rates on bonds were in double digits. Good stocks, as Kodak and Polaroid once were, can turn into bankrupts, as both did.

Diversification is the key to survival, especially for investors who either do not live by their computers or who, as many of us do, discount bad news that challenges our mental commitments to concepts we like. Few analysts believed Bre-X Minerals, which was seen as the biggest gold mine in the world, was a fraud until its price had collapsed to about zero. Same for Enron, the American energy trader and vast fraud.

Diversification is the essence of risk management. It is easy to do with investment funds. There are perhaps 30,000 ETFs and mutual funds available. The magic of these things is that the broader the mandate and the more diversified the fund, the lower the management fees tend to be. You can buy a U.S. or Canadian broad ETF for less than 30 basis points and even as little as 10 basis points of fees a year. One basis point is 1/100 of one per cent By definition, you will be getting an asset with average market risk, beta = 1.0. Hold the asset for a decade or two and you should have a tidy return. The historical average of North American markets is 6.5 per cent a year composed of dividends of about 4.0 per cent and price gains of about 2.5 per cent. Take off 3.0 per cent inflation and you have a real return of 3.5 per cent, which is not bad for a passive investment. Run all this by your financial advisor and see what reaction you get.

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The post-American election rise of U.S. and Canadian share prices appears to be the consequence of widespread belief that Trump’s administration will cut corporate taxes and create a protectionist bubble for American businesses. They will cocoon in their shelter of lower taxes and higher tariffs and thus generate higher profits. The spillover effect seems to have boosted Canadian share prices, especially those of banks that have reported better-than-expected earnings.

There is a downside to the Trump effect. The expansionary effects of his promise of less regulation appear to be generating higher inflation. The Federal Reserve’s nearly certain path of rising rates has shot the bond market in the foot. Rising interest rates mean existing bonds will fall in price until their yields rise to match the returns of new bonds.

Not all bonds will suffer equally. The worst hit bonds will be those with negative yields. Generated in Europe by the European Central Bank and the Swiss National Bank and in Asia by the Bank of Japan, bonds that return less than their sale price when mature were supposed to make banks pay little or no interest, which they did, to charge for maintaining savings accounts (until recently a Swiss specialty). Negative yields were also supposed to encourage consumers and businesses to spend and invest. Most of this was hope and, it turns out, the plan fizzled. Consumers figured that if banks and bonds paid very little, they would just have to save more. So negative pay bonds had the effect of stifling spending as much as encouraging investment in stocks or equipment.

Bond prices

Prices of investment grade bonds have tumbled in the wake of the anticipated Fed moves to higher rates. The collective world value of negative pay bonds has fallen by an astonishing US$2.5 trillion, according to Bloomberg. To get a sense of what this means, consider that U.S. GDP in 2015 was US$1.79 trillion. The benchmark U.S. Treasury 10-year bond’s yield has risen by 0.57 per cent from summer lows to 2.4 per cent. German bunds, which are the equivalent sovereign bonds of that country, saw their yields rise to 0.33 per cent in the first week of December from as low as minus 0.189 per cent in summer. Japan’s sovereign 10-year bond yield, which was 0.287 per cent in summer, rise to 0.41 per cent in the period, effectively a doubling in their return.

Higher interest rates around the world and more bond losses are a nearly sure thing. The path back to the historical average of five per cent for 10-year U.S. Treasury bonds and a similar yield for a 10-year Government of Canada bond is going to be long and painful for those who hold them. The strategic solution, of course, is to hold less by moving either to short bonds with terms of five years or less. They will have relatively little reaction to falling rates and, if bought at issue and held to maturity, they will have positive returns. It is also possible to buy laddered exchange traded bond funds that roll maturing bonds into higher yielding bonds. These laddered ETFS come in five- and 10-year versions in Canada with both government and corporate bond versions. In the U.S. there are numerous varieties that differ by term, class of issuer, investment quality, and taxability. Laddered ETF fees are usually less than half a per cent, but selection is problematic. Many investors work with advisors to make the right picks.

Bond-equivalent stocks

An alternative to buying bonds that are vulnerable to rising interest rates is to buy what many investors see as bond-equivalent stocks. Those are the big banks and, often, the big telecom companies and electrical utilities. All pay handsome dividends and all raise them from time to time, yet none are completely immune from trouble. These dividends, which, divided by stock price, generate yields of 3.5 per cent for the banks to as much as five per cent for phone companies. They sell at relatively reasonable multiples of price to earnings. For banks, that’s about 12. For utilities, about 17 to 20. Each is vulnerable to higher interest rates, yet their exposure varies from one company and industry to another.

Higher interest rates will means that big utilities and telcos will have to pay more when they borrow. They are heavy bond issuers, so their finance costs are sure to rise. Interest comes off the bottom line and that will reduce earnings. That’s why shares of some of the big utilities such as Fortis Inc. and the telcos like BCE Inc. are well below their 12-month highs. Banks, on the other hand, will see an increase in the spreads between what they pay to depositors and what they earn from borrows. That’s why bank stocks are near their 12-month highs.

No stock has the solidity of a bond issued by the company and no corporate bond is as solid as a provincial bond backed by the power to tax or a sovereign bond backed by the power to print money. Yet bonds have fixed lifespans. They live or die in that period. Stocks can live for many decades and that’s why stock investors as a group are probably more optimistic than dour bond investors who always know their time is running out.

In anticipation of higher interest rates to come, Canadian provinces have recently issued records amounts of debt. Provincial treasurers want to lock in relatively cheap money before interest rates climb higher.

For now, the smartest move may be to defer bond purchases for six months to a year when rates will be higher though not at their long-term average highs. Stocks have had a very strong run, especially bank shares. The wise investor does not start sprinting when most of the pack has already passed by. Chasing bank shares or any other is momentum investing and amounts to buying high. Too often, that leaves the despairing investor selling low when, inevitably, prices have tumbled.

And tumble they do. At the beginning of 2016, Canadian Pacific Railway traded at $160, down from $240 in the spring of 2015. It has recovered to $200 lately. BCE Inc. has fallen from $63 on July 27 to a recent price of $57. Unlike bonds, which have a known value at maturity, there are no price guarantees on stocks. But time is on their side and share prices may eventually rise.

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Here is what is going to happen and what is already happening in advance of the expected announcement:

• Short-term interest rates in the U.S. will rise by about a quarter of a per cent.
• Long-term rates for bonds and mortgages with terms of five or more years will tend to rise by a comparable amount.
• The line connecting all yields for all periods from one day to 30 years, called the yield curve, will tend to flatten, an omen for economic growth restrained by the central bank.
• Existing long bonds, those that have terms of 10 or more years, will start to lose value as new bonds with higher interest rates hit the market. Existing bond prices will fall a little.
• Companies with a great deal of debt coming due in a year or two will find their stock prices falling as investors anticipate that higher interest rates will reduce their profits. Utilities, railroads, insurance companies and banks are among the most vulnerable stocks.
• Bank share prices will eventually rise as investors perceive that term spreads (the difference between borrowing costs and lending rates) will grow.
• Insurance company stocks will recover as higher rates on government bonds (what insurance companies use for life insurance investments) raise profits and allow better deals for customers seeking new or renewed insurance policies.

Canadian interest rate increases are going to lag U.S. rate rises. In an Oct. 19 announcement, Bank of Canada Governor Stephen Poloz said Canadian rates would not rise in synch with U.S. rates. Slow economic growth, low energy prices, low non-energy export growth and a fear of triggering a made-in-Canada recession induced the BoC to hold the line. There was a discussion of lowering rates to stimulate the economy, but, reportedly, the BoC did not want to add fire to hot real estate markets in Vancouver and Toronto. On the other hand, tighter house mortgage rules are expected to reduce economic growth by as much as 0.3 per cent per year. The defensive stand of the Bank of Canada implies that Canadian interest rates will not begin rising until mid-2018 and that is if economic growth picks up rather smartly.

Until Canadian interest rate catch up to those in the U.S., the loonie will tend to soften. Canadian interest rates will eventually rise. They have always moved in synch with U.S. rates over long periods; over a period of five to 10 years, Canadian rate trends are going to match U.S. trends.

Investors’ moves

For investors in what is going to be a rising interest rate environment, the rate boosts that are coming imply a need for major portfolio review and adjustment.

As interest rates rise, solid, high yielding stocks will tend to be sold off to buy bonds. At first, there won’t be much competition between a telecommunications stocks like BCE Inc. with a 4.5 per cent yield taxed at a relatively low rate courtesy of the dividend tax credit and a five-year Government of Canada bond with a five per cent yield fully taxed. But government bond yields and corporate bond yields will rise along with the rising overnight rate. The move to higher rates will not be race to the top. It will be like watching a ballet in slow motion with many players moving carefully to avoid stepping on other dancers’ toes.

Still, in a couple of years, there will be a new hierarchy of desirable assets: for off-farm investors, Government of Canada bonds could have rates of three or four per cent for five years. Add one or two per cent to that for senior issues of the biggest and more trusted of Canadian corporations. Junk bonds tend to move in their own cycles, but it is a sure thing that they will have to add one or two per cent to the lower levels of investment grade bonds. Figure six to eight per cent for “good” junk, often just non-rated debt from solid but smaller issuers. But remember that corporate bonds are not as liquid as stocks.

It is easier and safer to buy into diversified bond mutual funds with annual management expense ratios of less than one per cent or exchange traded bond fund with MERs of one-third of one-per cent or less. But by all means consider (though not necessarily buy) bonds, but consult an investment advisor about selling and about costs.

Higher interest rates are coming to Canada, but not for at least 18 months. What happens in the United States will happen here. Watch U.S. investment markets for a preview and keep some cash on hand to buy into the bargains that will appear as rising interest rates known down some stocks and bonds.

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Some investors choose business ownership with all the risks that go with it. Businesses may also borrow from banks or directly from the public through bonds that promise definite payment at specified times and eventual repayment of the loan.

If we put a magnifying glass on capital markets that trade stocks and bonds, we’d find layer after layer of information about risk. Risk, after all, is what makes stocks go up and down. Bonds with absolute certainty of payment of interest and repayment of principal offer less risk and so attract investors who want certainty of payment of interest once or twice a year and exact payment of principal when the bond matures. Both stocks and bonds have the common characteristic that the greater the risk of loss, the higher the payoff has to be.

The question ultimately is how much risk to take. Too often, investors let others make their decisions, then find they have losses greater than they expected. Says Brian Roberts, who has a mixed grain and cattle farm on a section of land near Didsbury, Alberta, “I lost $172,000 in just eight months starting in mid-2015 with a portfolio constructed by an advisor who put me into bonds, a Cuban resource operation, energy stocks, real estate investment trusts and other assets I did not understand. I trusted him, so I did not ask the right questions. I took him at his word. Looking back, I should have tried to understand the investments. We made a little in good times, but we lost more when times were bad.”

You might ask, why bother to take a chance on risky stocks, which almost inevitably plunge from time to time, when a government bond, which is a sure thing, can be had with a phone call to an investment dealer or via a mutual fund of government bonds?

The answer is in the payoff. Jeremy Siegel is professor of finance at the Wharton School of the University of Pennsylvania. His research into stock and bond returns is used worldwide. He sets the standards and measurements of risk and return. Here is what he has found:

Using U.S. data, because there is so much of it and for much longer periods than Canadian data, Professor Siegel found that from 1802 to 2012, U.S. stocks had a compound annual return of 6.6 per cent, bonds 3.6 per cent, gold 0.7 per cent and the U.S. dollar — always eroding through inflation — -1.4 per cent. One U.S. dollar put into any of these categories and kept invested by an immortal asset manager running the portfolio for two centuries would have turned into $704,897 in stocks, $1,778 in bonds, $4.52 in gold or just one nickel, that is, five cents, in currency. That is why one buys stocks. The payoff is too huge to ignore, as Siegel shows in his book, Stocks for the Long Run. But what one must ignore is the propensity of stock markets to crash.

The stock market roller coaster?

Thus the paradox: Stocks have lost more than 20 per cent in brief periods as long as I have been investing. There was a flash crash of 23 per cent in 1987, then a down spike driven by interest rate increases in 1991, another crash in 1998 spurred by the almost simultaneous collapses of Long-Term Capital Management (a hedge fund in Connecticut), the wreck of Thailand’s currency, and Russia’s default on many of its bonds. In 2000 markets were sunk by the popping of the dot com bubble, then in 2001 by the tragedy of the Twin Towers, then in 2008 by the implosion of the mortgage market and the collapse of American investment dealer Lehman Brothers. Markets crash every decade and sometimes more often than that, even though statistics predict that declines of more than 25 per cent should only happen, on average, once every few hundred years.

Crashes reconsidered

You could say that only a fool would put money into such a roller coaster, but that would be wrong. Let’s reconsider those crashes. It becomes a matter of scale. If you watch stock prices minute by minute, as day traders once did before losing their minds and fortunes, you see tremendous volatility. A stock may rise or fall a few per cent in a matter of minutes but at the end of each day it will be close to where it started or to the market trend. A few companies may fizzle, such Enron or Bre-X, but most companies survive and eventually see their shares rise in price. The drivers are management, which must appease investors to stay employed, technical innovation and inflation.

Let’s look at stock prices again, now in a moving 20-year weekly average. Take any stock or major average, say the biggest 60 companies listed on the Toronto Stock Exchange, and write down its price at a given day, or take the five closing prices for the week and divide by five. Do this for 52 weeks a year for 20 years and move the average ahead by one week every seven days. The line will be almost perfectly straight with hardly a wrinkle. The angle will be the long-term return of stocks, say a six-degree up angle. Stick with the average and, in spite of crashes and other blowouts, occasional bankruptcies of a few companies, foolish ideas like the dot coms, which were tech companies often with no business plans at all, you should make a lot of money. All it takes is patience.

Let’s talk about patience. Seventy per cent of all returns of stocks are dividends. If you buy shares of a company with a history of paying dividends and raising them steadily, you will be paid in good times and bad. The dividends can be reinvested in the stocks if you wish via Dividend Reinvestment Plans (DRIPs), or taken as. Almost all of the biggest stocks pay dividends. Chartered banks pay in a historical range of three to five per cent of the stock price. Telecom companies like BCE Inc. pay four to five per cent. Add a conservative two per cent for annual increase in price of the stock and you have a probably rate of growth of, say, four per cent dividend and two per cent price or six per cent. A six per cent annual return, which is not even taxed if it is inside a Registered Retirement Savings Plan or in Canadian stocks inside a Tax-Free Savings Account, will make $1,000 grow to $2,191 in 20 years. If you add $100 a year for 20 years, the investment will become $5,288 in 20 years. Such is the reward of patience and commitment.

To diversify, do it yourself. There are many DIY lessons to be found the vast array of investment books and just by reading the financial press, or by watching financial news on television. Study and read and the odds are that, even with a few flops, patience and use of dividend paying stocks will let you build up a tidy sum. Add some growth companies that pay small or even no dividends, do your research yourself so that you have a feel for the assets you shop for and buy. That way, you’ll have a good shot at diversifying into profitable off-farm investments.

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Bonds, on the other hand, are for pessimists. As economic growth slows, the demand for loans declines. Inflation subsides. In this atmosphere, bonds thrive. Interest rates tend to fall, and existing bonds which promise fixed income at specific dates attract attention from investors seeking security and shelter instead of risk and market profits.

The problem with this model is that it works differently at different times. Today, for example, bond interest rates are in the low single digits. Investors need to park their money for decades just to get a few measly per cent interest. Should interest rates rise, prices of existing bonds with low payments, called coupons in the investment biz, will tumble in price. Even a one per cent pickup in inflation could shave as much as 30 per cent off the price of a strip bond, called a zero in the U.S. — it’s a bond that defers paying all interest until maturity.

The bond market has become a place where investors trade risk in how their companies’ stock might do for the assurance that high quality bonds, called investment grade bonds, will inevitably come through with interest payments and then return their capital. It is a most peculiar bet these days.

Here is an inside tip: The less risky a bond, the shorter its story. If you buy a Government of Canada bond or a U.S. Treasury bond, there is no story. You put up your money at your investment dealer, your account is credited with the bond you’ve bought and nothing more need be said. The odds that the government issuer will default are trivial. End of story.

A provincial bond or a municipal bond has a slightly higher interest rate. In Canada, if a federal bond pays 1.5 per cent for 10 years, a Government of Ontario bond will pay two per cent, give or take. The bond shopper should be concerned with the health of the Ontario economy, the history of defaults by the Province of Ontario (never), and the market’s taste for Ontario bonds (always strong).

Move to a high grade corporate bonds, such as a 10-year Bell Canada Inc. issue, and you can get three per cent as I write this column. Bell has a longer story. It’s an active phone company, its traditional products, wireline phones and related products, are dying out. It has entertainment assets and some information media — always fragile. But for 10 years, it’s a good bet. Still, you’d want to go to a credit rating site like DBRS (formerly called the Dominion Bond Rating Service), discuss the bond with an investment dealer or check it out in the database of an online brokerage before buying. Lower quality bonds have longer tales about recovery of business, clever management, etc.

The paradox of the bond investment business is that, given the very low interest rate coverage that all investment grade bonds offer these days, the investor’s greatest risk is inflation and higher interest rates. You can mitigate that risk by reinvesting every single coupon — most pay every six months — at the higher rates of interest should they prevail. You can do this if you have millions of dollars in bonds, but the theory does not work with just a few thousand, for bonds come in $1,000 issues or “pieces” as they say in the financial business.

Rather than do all the research to buy a single bond, you can buy a bond exchange traded fund. There are many. The big exchange traded fund managers such as iShares have many types of bonds. You can buy the broad Canadian bond market, U.S. Treasuries with short or long maturities, or bonds laddered from one to five or one to 10 years so that if rates rise, the fund will roll maturing bonds into new issues with higher rates. There are bonds that link their payment rates not to interest rates, but to inflation rates. Much like buying a custom made suit, you can get whatever fits.

The four secrets

Here are the secrets of buying bonds without getting beaten up by rising interest rates.

1: Buy bonds as a complement to stocks.

If you have just investment grade bonds, you have a lot of naked exposure to interest rate changes. These days, there are negative rates on 10 year government bonds in Japan, Switzerland, Germany and some Nordic countries from time to time. Why people buy bonds guaranteed to be worth less at maturity than at time of issue is a mystery wrapped in an enigma, as Churchill said of Russia on the eve of World War II. Regardless of motives, they can be explained in the complexity of global bond markets: if interest rates fall even further, existing negative pay bonds will be worth more than bonds that pay even less. But you, an off-farm investor, do not want them. The great rule of bond investing is this: stick to plain vanilla bonds with positive interest, few stories, issued by governments you trust or strong companies.

2: Do not chase bond yield.

You could buy a Sherritt International bond with a 7.5 per cent coupon due Sept. 24, 2019 at a price discount so steep that $480 upfront buys you the $1,000 face value. The bond at this price offers a 35 per cent yield to maturity. This is investing for the brave. The market worries about Sherritt, which is a mineral miner with a lot of money tied up in the developing world. The rule: if you buy high yield bonds, or junk as it is called, be prepared for a side order of agony with your profits. If you have a taste for junk, buy a junk bond fund which offers diversification and expert management, and don’t buy too much. In defense of junk, it always ranks ahead of stocks in safety, for each issuer has to pay interest or be put into bankruptcy. Junk bonds tend to do well when economies thrive and interest rates rise.

3. To eliminate all risk of loss, buy bonds for a purpose with a date.

For example, buy bonds that mature the year your child starts university. You may pay more than issue price these days, for example, $1,490 for a $1,000 Government of Canada issue due June 1, 2037. You would lose $490 on the price if you hold to maturity, but you are compensated by the 5.0 per cent annual interest on this bond, which is a few percentage points higher than what new 21-year federal bonds would pay. You pay more, you get more. The capital loss is a problem for your accountant.

4: Migrate a stock portfolio to bonds slowly.

The common wisdom is that as you get older, there is less time to recover from stock market crashes. Bonds act as cushions, so you can go from 50 per cent stock/50 per cent bonds at age 50 to 30 per cent stocks and 70 per cent bonds at age 70. You give up a lot of growth in the process, for stocks always beat bonds over periods of decades, but you gain security.

We are in the fourth decade of the longest bond bull market in history. This one started in 1983 when interest rates paid on term deposits were in the high teens. Bonds have been among the most profitable investments in this period, but it cannot last. Thus bonds do provide security with their fixed and perfectly known future prices at maturity. But don’t over pay for that guarantee. Life is risk.

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